Emerging markets debt funds look to quality issuers

Most fund managers are positioned for emerging markets to lead slow global growth, with China and Asia in the vanguard and a bias to quality issuers, according to the latest sector review published by Standard & Poor's Fund Services.

Managers, such as the team at BlackRock, say the bias to quality issuers is partly as a defence against any future contraction in liquidity but also because they believe the big beta trades of 2008 and 2009 will be replaced by greater country differentiation. "They are not increasing or avoiding pure corporate credits and are only investing in quasi-sovereign names or corporates that are strategically important to the country," notes S&P Fund Services analyst, Kate Hollis. "Managers with pure corporate exposure are keeping individual positions very small."

Despite the bias to quality names, most managers are underweight countries that trade very close to Treasuries, such as China, as they believe this adds interest-rate duration risk without adding sufficient spread.

All managers have been cautious on local currency duration, as central banks in emerging markets countries decouple their monetary policies from G3 countries. The only exceptions have been in Eastern Europe, where managers have had duration mainly on a currency-hedged basis, or in Mexico, as it is more tightly linked to the US.

Hollis noted that despite extensive conversations about Greece, no manager expected it to be included in emerging markets indices at the moment, although some felt it might fall into this category in a few years' time.

There was a strong rebound in emerging markets external debt funds in 2009 as risk appetite returned, with local currency debt underperforming external debt for the first time in several years. The external debt funds that did well against competitors in 2009 tended to be those that did worst in 2008 as troublesome credits rebounded. Many of the top-performing issuers in 2009, such as Iraq and Ukraine, were the worst performers in 2008. Meanwhile, Asian bond funds underperformed both the global external debt and local currency peer groups.